418 F.

2d 829
70-1 USTC P 9103

VANGUARD RECORDING SOCIETY, Petitioner-Appellant,

v.
COMMISSIONER OF INTERNAL REVENUE, RespondentAppellee.
No. 67, Docket 33461.

United States Court of Appeals Second Circuit.

Argued Sept. 30, 1969.
Decided Nov. 26, 1969.

Jerome Kamerman, New York City, for petitioner-appellant.

Janet R. Spragens, Atty., Tax Division, Dept. of Justice, Washington, D.C.
(Johnnie M. Walters, Asst. Atty. Gen., Lee A. Jackson and Harry Baum,
Attys., Dept. of Justice, on the brief), for respondent-appellee.
Before FRIENDLY, SMITH and FEINBERG, Circuit Judges.
J. JOSEPH SMITH, Circuit Judge:

Taxpayer is a New York corporation which keeps its books on an accrual basis.
From 1957 to 1963 taxpayer's accounts payable control account exceeded the
total of the individual accounts payable by $8,475.75. Taxpayer was aware of
this, but allowed the discrepancy to be carried on its books (noted only by a
pencil entry in the control account) until it had to have a certified accountant's
report, in which no discrepancies could be carried. So for the tax year ending
March, 1963, taxpayer debited the accounts payable control account so it would
accord with the individual accounts and credited the same amount directly to
earned surplus. Since this amount was not taken through an income account,
the Commissioner sent a notice of deficiency on October 27, 1966, on the
ground that the credit to earned surplus in 1963 was the recovery of accrued
expenses which had been deducted in a year prior to 1957. The Tax Court,
Mulroney, Judge, approved of the Commissioner's determination in a written
opinion. (51 T.C. 819 (February 20, 1969).) We find error and reverse and

remand with instructions.

2

The facts are not in dispute. The discrepancy was first noticed in 1957, when
taxpayer hired a new accountant. He made a 'cursory' attempt to locate the
source of the problem, but was unsuccessful. At trial, he speculated that the
discrepancy arose through common careless bookkeeping-- for example,
'forcing' a balance by arbitrarily increasing the control account-- but since the
books for years prior to 1957 were no longer available he was unable to be
more definite or to testify as to the initial tax consequences of the discrepancy.
Both sides agree that if the excess in the control account had been expenses
accrued and deducted by taxpayer prior to 1957, then the recovery of that
amount now by book recognition that no obligation is owed and by crediting
earned surplus would give rise to income in the year recovered. Providence
Coal Mining Co. v. Glenn, 88 F.Supp. 975 (W.D.Ky.1950); Lime Cola Co. v.
Commissioner of Internal Revenue, 22 T.C. 593 (1954); cf. FidelityPhiladelphia Trust Co. v. Commissioner of Internal Revenue, 23 T.C. 527
(1954); Internal Revenue Code of 1954, 61(a)(12), 26 U.S.C. 61(a)(12) (1967).

The Commissioner contends that the burden is on taxpayer to establish that a

deduction was not taken. Whether a deduction was taken, however, is not the
question here, for if an earlier deduction was erroneously taken, the policy of
the statute of limitations would prevent the Commissioner from recovering on
the basis of the erroneous deduction now,1 Mertens, Law of Federal Income
Taxation, 7.34, at 88 (rev. ed. Zimet & Oliver 1962); cf. Commissioner of
Internal Revenue v. Schuyler, 196 F.2d 85, 87 (2d Cir. 1952), while if an earlier
deduction was in fact properly taken, it must have been for a definite liability
fixed at the time. If there was such a liability and it was forgiven, forgotten or
eliminated in some manner in 1963, income was then realized by the taxpayer
whether or not he took a deduction earlier. The question of the earlier deduction
is therefore not controlling here. What is in issue is whether there actually was
a preexisting debt and, if there was, whether it was forgiven in 1963 or the
taxpayer wrote it off then because he determined that it could not or would not
be enforced. There is a complete lack of evidence that the taxpayer so
determined. The only evidence, apparently credied by the Tax Court, was that
the write-off in 1963 was solely for the purpose of balancing the books. There
is no real reason to believe that there ever was a debt in the first place. The
examination of the books by the bookkeepers or accountants, however cursory
it may have been, should at least have turned up the account from which this
amount had been dropped if it existed. And since there was no evidence such a
debt ever existed, there is no indication that there was in 1963 or at any other
time a forgiveness of a debt or a determination that it could no longer be
enforced.

The Commissioner relies on Lime Cola v. Commissioner of Internal Revenue,

22 T.C. 593 (1954). In that case flavoring was purchased in 1930, was found to
be defective and never paid for. The purchase price was written off from
accounts payable in 1942 and credited to earned surplus. The 1930 books were
not available at the time of trial. The taxpayer was held not to have met his
burden of showing that he had not taken a deduction in 1930. That case is, of
course, distinguishable from this, for in Lime Cola the source of the
bookkeeping entry was known to be the purchase of flavoring, and the Tax
Court was entirely justified in assuming that this item had been deducted in the
absence of contrary proof. Here we do not know the nature of the item or
indeed whether one existed.

This case more closely resembles Pittsburgh Industrial Engineering Co. v.

Commissioner, 9 T.C.M. 1132 (1950) where the Commissioner sought to treat
as income in 1941 book adjustments in control accounts to actual detail as of
December 31, 1941 and January 1, 1942, reflecting a net increase in surplus.
Since all the amount reflected in the book adjustments resulting in the increase
in net surplus arose before 1941, it was held error to include it in income in the
taxable year 1941, the Tax Court stating: 'The petitioner did not attempt to
show in what year or years prior to 1941 the amount reflected in the net surplus
increase accumulated, nor do we think it was required to do so, since the year
1941 is the one before us.'

It is contended that a ruling in favor of the taxpayer is a reward and

encouragement for sloppy bookkeeping. This does not follow. If an account
payable should be dropped out in any year by a taxpayer, he would have to pick
one which he could predict would be eventually forgiven or forgotten by a
creditor, a highly dubious undertaking. In the case at bar, of course, there is no
question at all raised as to the taxpayer's good faith. Bad faith would put the
matter in a different light and raise the possibility of criminal and civil fraud
remedies and tolling of limitations.

The Commissioner's determination that the correcting entry represented a

cancellation of an indebtedness constitutes only his self-serving speculation. A
determination which is only this should not cast the burden of rebuttal on the
taxpayer. See Helvering v. Taylor, 293 U.S. 507, 514-515, 55 S.Ct. 287, 79
L.Ed. 623 (1935). The Commissioner's determination must be set aside as
purely arbitrary.

The decision of the Tax Court is reversed with instructions to enter judgment
for the taxpayer disallowing the deficiency assessment.

Even if taxpayer in Lime Cola had not taken a deduction for the goods in 1930,
the recovery of the debt owed by the writing-off of the account payable in 1942
may have given rise to income in that year. The fact that taxpayer faied to take
advantage of an availabled deduction in 1930 would not seem to detract from
the conclusion that the discharge from indebtedness in 1942 was income. This
is most clearly seen if it is posited that no deduction was taken in 1930 since
the taxpayer had no taxable income in that year. Of course if the taxpayer in
Lime Cola could have shown that no deduction was taken in 1930 then it could
have argued that it only recovered the value of the defective goods (since that
was the measure of its obligation under contract law) and not the full amount of
the account payable